Here we go again it may seem to many. The Fed is preparing us for a policy tightening just when a powerful growth cycle upturn is faltering. Or is it in fact an example of another well-known type of error from Fed history—getting behind the curve of rising inflation? The most plausible answer is that it is neither.
Instead, the huge monetary inflation shock which the Fed has administered so far in this pandemic means that the “normalization steps” now in prospect for 2022 are all but irrelevant to macroeconomic prospects or asset market price trajectories.
The more Federal Reserve chief Jerome Powell has been huffing and puffing, since his renomination (November 22), about normalizing policy, the steeper has been the fall in long-term interest rates. In the first two trading weeks following the renomination, the ten-year yield on US Treasurys was down by thirty basis points to 1.35 percent. A coincidence, surely, explained in part by the possible Omicron menace? Yes, perhaps in part, but not altogether.
The chief’s performance is now in the theater of the absurd. Many in the marketplace have deserted the audience, though the noise still irritates them. Instead, they focus on the drama of monetary reality. The title? “Lost Illusions on the Journey from Mega Pandemic Inflation to Great Depression.” The evolving mood of the audience here will have a powerful effect on financial markets and ultimately the global economy.
Toward understanding the theater of the absurd and its triviality, recall the story of the natural history museum renowned for its dinosaur relics. The guardian there, quizzed by a child as to the age of those specimens, answers: 5 million years and 90 days. How so? Because when he started work there, around three months ago, he was told their age was 5 million years!
And so it is with Chief Powell’s explanations. All he talks about and is asked about, whether in Congress or by invited journalists, is the equivalent of those ninety days. No mention of the huge fact that from the onset of the pandemic to now he has presided over a near doubling of the US monetary base (from $3.4 trillion to $6.4 trillion) while imparting a massive inflation shock to the US and global economies.
How that doubling of the base and accompanying tremendous monetary inflation will work itself through economies and financial markets in coming years surely transcends all the tinkering with temporary semipauses to quantitative easing (QE) and minute rate rises which Chief Powell has in store for us next year and beyond?
The monetary Machiavellianism of this administration in renominating Jerome Powell as Fed chief, counting on most Republican senators to support him, has a principal aim: the Democrats will not get the full blame in the event of large monetary woes emerging—whether high inflation persisting or a crash and great recession. A not unreasonable objective, the student of the real monetary drama might say, given that such a large part of the pandemic monetary shock occurred under the Trump administration.
Nothing new here. This political art of a new administration reappointing the sitting Fed chair despite suspicions of huge failures to date has precedents. Think most recently of President Obama renominating Ben Bernanke in 2009. This time, however, there is no Senator Bunning to interrupt the monotony of the theater of the absurd by defiantly exclaiming at the renomination hearing (as he did on the occasion of Ben Bernanke’s renomination), “You are the Moral Hazard!” In both the Obama and Biden cases of Fed chief renomination the cynical observer might suspect the renominee has made a commitment to back (both publicly and in Congress) a new wave of financial regulations or the equivalent.
Investors absorbed by the theater of monetary reality still have plenty of distraction to cope with. This includes on the one hand the debate between two long-time prominent inflationists, Larry Summers and Paul Krugman, and on the other hand the victory celebration of the monetarist commentators.
Larry Summers as leading Bloomberg contributor opines that we are on the road to 1970s-style high inflation unless the Fed raises rates by four tiny steps next year while pausing QE 2 months sooner than planned. Paul Krugman hypothesizes whether we are now replaying the post–World War 2 inflation, which will burn itself out as back then without any serious explicit policy tightening by the Fed—rather a fading of war-related bottlenecks and a shrinking of real money supply as a consequence of the run-up in goods prices.
The monetarists say they told us so. The bulge in M2 ($15.4 trillion to 21.2 trillion from February 2020 to October 2021) has translated into the inflation shock of 2021–22. They predict much more is to come and generally, strangely in common with some leading Keynesians (including notably Larry Summers) expect present high inflation to somehow get built into expectations of future inflation which monetary policy makers will find politically very difficult to combat.
Yet there is an emperor’s-new-clothes aspect to the monetarist story. In our corrupted monetary system, high-powered money (monetary base) has long since lost the distinguishing features which meant demand for it was strong and stable. The M2 aggregate suffers from the same problem, and it is eminently possible that 2022 will see a contraction of M2 as funds move from deposits into short-maturity T-bonds.
Yes, we can agree that the monetary explosion of 2020/2021 has been the source of a big inflation shock, including asset markets and goods markets. Monetary diagnosis is overstretching credulity, however, if it makes highly confident predictions about how far ahead and steep is the road to the hump of the hill for the late pandemic price rises and how long is the plateau or gentle upward slope for prices beyond that.
The inflation expectations story, retold today by the unholy alliance of monetarists and Keynesians and popular in expositions of the greatest peacetime inflation in the US (mid-1960s to late 1970s), is not convincing.
Back then, in the mid-1970s, in the context of a second great monetary inflation shock from the Arthur Burns Fed (1976–78), it seemed casually as if inflation expectations were feeding ongoing inflation. Today, we are in a totally different situation. The global economy reveals sluggishness due to previous huge credit excesses and related malinvestment and to advancing monopoly capitalism.
A focus of monetary analysis should now be the potential for vast asset inflation which has built up to go suddenly into reverse—with the key dangers here being the fantastic speculative narratives sustaining hypervaluations of a few mega-high-flying stocks, together with still scorching-hot global credit markets overall despite important cooling in China and smaller isolated areas.
A buildup of bad news from credit markets would not this time find the Fed and ECB immediately poised to roll out massive security purchase programs. And there is no guarantee that even if forthcoming they would accomplish their tricks this time. A key ingredient of the 2020–21 credit bailout was the inflation tax; this was not just collected by big government but also in particular by highly leveraged debtors from their creditors. The unfolding real monetary drama may well not repeat that act before the curtain falls.
That exercise most likely cannot be repeated at this stage. The Fed is pausing monetary base hyperexpansion while the peak of the near-term price hump is within sight as supply constraints ease. And in Europe, the new coalition government in Berlin, despite all its euro-solidarity talk in its founding document, is likely to be strongly opposed to renewed ECB bond purchase programs at a time when Consumer Price Index inflation, excluding booming house prices and rents, is running at 6 percent year on year.